Chinese equities lagged gains in Western markets during the past four weeks as Beijing’s regulators pressed companies to reduce debt. Property developers, the most levered sector, performed worst in Hong Kong after several members of the Hang Seng China Enterprises Index announced secondary offerings. Secondary issues dilute the stake of existing shareholders.
Deleveraging has become the meme of the day in China market commentary. Asia Times noted the trend last week (“China Deleverages While the Sun Shines,” Dec. 3), and Bloomberg News weighed in on the theme yesterday (“China’s Financial Markets are Starting to Price in De-Leveraging,” Dec. 8). A flood of equity issuance, including both initial public offerings and secondary issues, has lowered China’s overall leverage ratio since 2015. American companies meanwhile have taken on more debt and bought back their existing shares, increasing their leverage.
Although deleveraging dampens equity price gains in the short run, it will improve China’s balance-sheet stability in the long run. That improvement is already reflected in market gauges of risk, which show that the riskiness (expected volatility) of the Chinese market has converged with America’s.
The past month has been painful for investors in China’s property sector. The chart below shows the worst-performing components of the HSCEI. Most of them were property companies that announced or were expected to announce secondary offerings (shown in blue bars).
Chinese stock markets are flooded with new equity supply, including a record volume of IPOs, numerous secondary offerings, and an estimated $722 billion of management shares from earlier IPO’s that will be unlocked in 2021, the delayed effect of existing supply.
Secondary offerings that prompted sharp falls in the issuer’s share price included $2.33 billion from the developer Longfor, the smartphone manufacturer Xiaomi, and the food delivery service Meituan.
China’s point man in the deleveraging campaign is Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission (CBIRC). Earlier in December he made headlines by warning that property market debt constituted a bubble that had to be brought under control. Property loans represented a “grey rhino” risk to the financial system, comprising 39% of banks’ total portfolios. In a Singapore speech on Dec. 8, Guo warned that Fintech innovation created vulnerabilities for the financial system, including the danger that tech giants would use their monopoly on data to suppress competition, a Chinese government press release stated.
China rarely advertises an important policy move until it is well underway, and in effect irreversible. The blink-and-you-missed-it recession in wake of the COVID-19 epidemic gave the government the pretext to allow a number of prominent companies to fail, including BMW’s state-backed joint venture Huachen Group, as well as Yongcheng Coal and Electricity, which defaulted on a 1 billion yuan ($151.9 million) bond in November. Like Rahm Emanuel, Barack Obama’s first White House Chief of Staff, Beijing never lets a good crisis go to waste. China’s state-owned enterprises constitute an important political power base, offering employees an iron rice bowl. They are notoriously resistant to change and have been a capital sink for the past decade.
Western analysts frequently miss the point. For example, the Rhodium Group wrote a report on Nov. 12 entitled, “A crisis of faith in China’s corporate bond market.” The report stated: “A wave of defaults among state-owned enterprises (SOEs) has brought China’s corporate bond market to its darkest moment in history. Financial statements cannot be trusted. Government promises have proved empty.” On the contrary, the object of the defaults is to disable the political opponents of economic reform and clean up the corporate bond market.
In fact, deleveraging has been underway for several years. For the first time, the rate of credit growth in China fell below that of the United States, according to data published by the Bank for International Settlements. Total credit to the non-financial sector in China fell to a single-digit growth rate during 2020 while US credit growth spiked to a record 15% year-on-year.
Corporate leverage has been falling in China since 2016, while US corporate leverage has grown. The debt-to-equity ratio of the Shanghai Composite Index, jumped from 130% in 2011 to 170% in 2016, before gradually recovering to its earlier level. China used rapid credit growth to avoid recession after the 2009 global financial crisis. We observe, parenthetically, the opposite pattern in the S&P 500; highly levered US companies reduced their gearing in the first years of the post-2009 recovery, and then increased leverage sharply after 2016.
The jump in China’s stock market leverage made Chinese equities riskier. The market’s measure of stock market risk, the price (or “implied volatility”) of options on the broad stock market, rose accordingly. During 2016, at the peak of China’s credit boom, the implied volatility of options on the large-cap Chinese equity ETF (ticker “FXI”) traded consistently above that of comparable options on the S&P 500. By 2019, the implied volatility of options on US and Chinese stocks had converged, in large part due to already-successful deleveraging of the Chinese corporate sector.
It’s hard to tell how long the doldrums in China’s stock market will last. Chinese stocks underperformed during the past month. The S&P 500 returned about 3.2% over the month, while the CSI 300 market fell in dollar terms by about 0.25%, and the large-cap ETF FXI fell by 4.8%.
In the long term, though Chinese stocks should outperform. The earnings yield on the S&P 500 is less than 4% (that’s the inverse of the price-earnings ratio, now at a record 29%), vs. an earnings yield of 6% for the CSI 300.
China offers half-again as much earnings per dollar invested, and roughly the same degree of risk (using the market’s benchmark of implied volatility).